Discipline and Risk

As per Steve's comment and interest on discipline and risk, I will delve into what they mean and why they are incredibly important to trading.

First, what do I mean by risk? Risk is the amount of capital you are willing to lose if the trade does not go your way. It is where you place your stop loss for your whole position. Why is this important? Because you must always prepare for the worst before you enter into a position. You must always assume the worst and if you are wrong, you must limit your loss to preserve capital for another trade, for another day. The reason why buy and hold strategies do not work in the long run is that even though this investor's "win percentage" is very high, the one time that he holds onto a stinker (I will illustrate an example), he will lose it all.

Without using an extreme example, in the cases of extinct companies like LEH and BSC, I will use a company like Yahoo (YHOO) that is alive and well. Let' say an investor thought the prospects of the company were looking up as recently as 2 years ago and believed its pricing between the 20s and 30s was cheap. He would enter into a position in the 20s. He would check his portfolio several months later and see the stock hovering in the same price range. He would either buy more or let it ride. Now Q3 2008 arises and he sees the stock slipping to the low 20s. He would buy more because the company is "cheap," since he viewed it as cheap in the 20. And then fear hit the market late 2008. He views all his positions in his portfolio all down double digits. Will he give up on his positions, or will he buy more? And if he does buy more, does he use the same position size as before, or more or less? Those are all questions that a buy and hold strategy do not cover, because that strategy assumes that your choices are never wrong, that your opinion on the pricing of the company is accurate and that stocks tend to rise in the long run. You are playing the role of "smartest in class." You can see how this situation becomes destructive if you so happen to invest in a failing company.

Even though I am biased towards a certain way of playing the game, this blog is not about pitching a certain system. You can certainly play the smartest guy role if you so wish but more importantly, my point was to show the importance of having a stop-loss. Using this powerful tool let you know exactly how much you are willing to lose, barring an overnight gap or liquidity issues. Everyone knows that most people lose in the markets, so people should play in a way to limit these losses. You must also be discipline with following through with your stop-loss. This means, after your preparation, you will not move your stops to give it a "little more room" because you have already accounted for that through your preparation. I have done this a few times and my original plan always worked out for the better. How to properly use stop-losses so that you won't be "shaken out" before the real move is a different story that requires study and preparation on the stock, but that only comes with experience. Finally, one must be at peace with losing when it happens (and it most definitely will happen). If you cannot accept losses, do not play this game. If you only want to win, play a video game.

If you are fortunate to be holding onto a winning position, it takes discipline to hold onto such a position without cutting your profits short. The only way you make up for your small losses are through big winners. Many inexperienced investors will hope for a rebound in a losing position but fear for profits in a winning position. How many times has your parents or friends complain about how they sold their position too early but smiled about how they were "long-term" investors once they were out of the money? Your mindset needs to be the exact opposite. Stocks that are acting well tend to stay that way, and vice versa because markets tend to trend. Until you have a reason to exit your position, which is different for everyone and will come with experience as well, you have to hold onto your position. Otherwise, you cut yourself and your hard work short of what the market could have rewarded you. Another aspect of trading to keep in mind is that the entry and exit points of the greatest traders are almost never at the top and bottom. Think about it. You never know if a certain price is the top for a stock until it is.

Discipline with a position cannot be exactly replicated unless you have experienced the emotional rollercoaster, but there are ways to practice. The most effective way is to be in control and strong-willed in your life. Do the things you set out yourself to do and accomplish those goals. Trading, in many ways, is a reflection of who you are in life. Your risk tolerance, your emotions will all affect your trading system and style. Do not think for one second that if you have a breakup with your boy/girlfriend, you will not be affected by it. One must maintain a strong mind and body to trade.

Feel free to post comments, I will respond and appreciate every one.  Also, if you would like me to discuss a certain topic in my next post, post it in the comment section as well. Until then, never leave home without a stop-loss.